ECONOMIC AFFAIRS: Radical bank reform that could help end economic instability

by Colin Teese

News Weekly, December 8, 2012

The world financial system, as we all know, is drowning in debt. Although it is not the only thing wrong with the world economy, it remains nevertheless the main drag on world growth prospects.

1930s-style austerity packages, with a record of failure behind them, have proven once again not to be the answer. Nor are Keynesian-type stimulus packages the answer. The first slows still further an already stalling economy; the second seeks to restart a growth engine, but has done little more so far than add to the level of government indebtedness without lifting output and employment appreciably.

The two main instruments for determining the level of total spending in a national economy — the central bank’s conduct of monetary policy and the government’s conduct of fiscal policy through taxation and public spending — are in need of radical overhaul.

With this in mind, a couple of International Monetary Fund researchers, Jaromir Beneš and Michael Kumhof, have prepared a 71-page working paper entitled The Chicago Plan Revisited (August 2012).

The IMF makes it clear that the document expresses the views of the authors; but since the two men are employees of the IMF, we may assume that their ideas are not regarded with disfavour in the upper reaches of the organisation. Thus, the paper will carry influence, as it were, by association.

The late Professor Milton Friedman at the US Department of Treasury’s

Bureau of Engraving and Printing (BEP), Washington DC.

Beneš and Kumhof are revisiting an idea first put forward by a group of economists from the Chicago School of Economics back in 1936. Then the focus was on the problems created for the United States as a result of the Great Depression, which saw economic output collapse and joblessness soar to as much as 30 per cent of the workforce. Irving Fisher and Henry Simon, leading lights at the University of Chicago, were among the driving forces behind the idea.

The Chicago economists believed there was a need to separate monetary and credit-creation functions. In the US, both functions were vested in private banks. Those behind the plan believed that only by severing this link could the needs of the wider economy be appropriately served.

What was being proposed in 1936 amounted to nothing less than an assault on what had been a long-held privilege of private banks — the exclusive power to create credit. The Chicago Plan idea would turn back the clock some 250 years and empower the government to once more take sole responsibility for the creation of credit.

The architects of the Chicago Plan outlined the important advantages they believed would flow from this change (which in today’s parlance would be called “reform”).

To fully appreciate the Chicago Plan’s advantages, we need first to understand how credit is created now, and what would change under the proposed reforms. Contrary to popular belief, banks do not issue credit by drawing on their subscribed capital and the relatively small amount of personal savings lodged with them for safekeeping at nominal interest rates.

Private banks actually create credit out of nothing and lend it to borrowers at an agreed interest rate — usually for some purpose associated with business or for house purchase. The bank records the borrowed sum on its books. In the process, the borrower’s debt becomes a bank deposit against which the borrower is able to write cheques or withdraw cash.

That same deposit can then become the basis for another loan. Thus, the private bank is able to create money and lend it to customers at a profit, in what is a perfectly legal transaction.

Under this arrangement, private banks lend sums far in excess of their own capital holdings and reserves. In return for this privilege, the government requires them to lodge, as security, a small proportion of their potential obligation to depositors.

In straightened financial circumstances, rumours creating doubts about bank solvency can lead to panic and cause all depositors to try to exchange their deposits for cash. To guard against the adverse consequences for the total economy of “runs on the bank”, governments have had to stand ready to bail out banks with community — or, if you, prefer, taxpayers’ — money. The default position of private banks is underwritten by government.

Perhaps this reality was high in the minds of those who devised the Chicago Plan.

Instead of the government requiring banks to provide security for only a small part of their financial obligations, the plan would require US private banks to secure 100 per cent of depositors’ funds. Today’s fractional-reserve banking would be transformed into 100-per-cent-reserve banking.

Of course, this would require banks to develop an entirely different business model.

Securing depositors’ holdings would be an important gain from the Chicago Plan, but that alone would not justify it. Other less drastic means could deal with that problem.

The more important problem with the present arrangement is that it leaves entirely in the hands of private banks both the creation of credit and the management of the flow of money into the real economy. In this way, monetary policy is coupled with the profit objectives of the private banks.

This creates a classic conflict of interest. The banks’ requirements to maintain profits from credit creation may result in more or less money being fed into the real economy than is desirable for maintaining economic stability.

The Chicago School economists back in 1936 thought that was bad policy. They argued that effective control over the creation of money was a matter for the US government to decide in the national interest. Private banks, functioning correctly, should be able to offer credit only within the limits of their own asset backing.

This brings us to a later representative of the Chicago School, the late Professor Milton Friedman. He and Anna J. Schwartz undertook a detailed statistical analysis of the relationship between the behaviour of the US money supply and the behaviour of the US business cycle from the time of the US Civil War onwards. They summarised their findings in an 888-page scholarly tome, A Monetary History of the United States, 1867–1960 (Princeton University Press, 1963).

They argued that the 1930s Great Depression was caused by the US Federal Reserve perversely contracting the American money supply by a third between 1929 and 1933, and that the post-World War II inflation was caused by the money supply being allowed to grow at a faster rate than economic output. Too much money chasing too few goods, Friedman maintained, pushed up prices and led to inflation. Too little money had the opposite effect: it depressed demand, reduced investment and meant that the economy could not reach its full potential.

Friedman’s prescription for stabilising the economy and ensuring a non-inflationary growth of total spending was to ensure that the money supply grew at a steady pre-ordained rate related to the growth in the underlying productive potential of the economy — hence the term “monetarism” which commentators used to describe his ideas. In 1976, he was awarded the Nobel Prize for Economics.

Friedman knew, however, that his program for economic stability depended upon effective control of the money supply. With private banks able to inject money into the economy in what seemed to be a never-ending variety of ways, it was difficult to define money, much less to control it.

Probably for that reason, he became a strong supporter of the 1936 Chicago Plan.

It will be obvious that allowing the control of money to pass into government hands in the way the Chicago Plan envisages does not separate credit creation and monetary policy, but reunites them in the hands of the government.

Some will say — without reference to the scheme’s supposed benefits — that it would be unwise to trust governments with responsibility for credit creation. It would be better, they say, to keep in place the present imperfect system, with independent central banks trying, indirectly, to manage the supply of money, while leaving actual credit creation in the hands of the private banks.

Unfortunately, that system does not seem to work. In the US, for example, economist Alan Greenspan — one of the current system’s architects — was chairman of the US Federal Reserve from 1987 until 2006, the eve of the 2007-08 global financial crisis (GFC), which came close to bringing down modern capitalism.

Beneš and Kumhof have shown that a properly orchestrated policy of government responsibility for money creation and distribution along the lines of the 1936 Chicago Plan could generate important benefits.

Privately-created credit automatically creates debt — a great money-spinner for the banks, but with a capacity to harm the economy. Its fundamental purpose is not to feed the optimum volume of money into the economy, but to deliver financial benefits to bank shareholders.

Government credit creation, linked primarily to managing monetary policy, would better serve the national economy and business; there will be no debt associated with government creation of money. Government-created credit becomes a community asset rather than a liability — providing that credit flow is aimed at maximising economic output.

Some of the other benefits are obvious. Government outlays on the infrastructure necessary to sustain private business and community needs can be properly coordinated and financed without recourse to debt. And the cost of business borrowing for investment could be significantly lowered.

The savings from these benefits would, presumably, be passed on to consumers in the form of lower prices. Overall, these advantages would allow governments to lower taxation, make housing more affordable and deliver better community services.

The IMF has allowed the publication of this working paper, developed by Beneš and Kumhof, in order to encourage discussion. Let us hope that indeed happens.

Its authors appear to have a different, though perhaps related, purpose. Their purpose was to construct an economic model of what the authors of the original Chicago Plan claimed were the benefits of the plan. Beneš and Kumhof’s modelling suggests that the plan could deliver even more than was originally claimed for it back in 1936.

What then are the chances of the plan receiving favourable attention in the US? So far, only the Japanese government has contemplated doing something similar.

Private banks in the West, which stand to lose most, will certainly oppose the idea. Businesses, even though they would gain from the scheme, may still be wary about a reform which would fundamentally reshape the economy.

In modern democracies, such as the US, various special interest groups are able to exert enormous influence over the shape and direction of economic policy. Nothing can be done without their support.

Things would probably have to get much worse before such a radical reform could win their support.

Colin Teese is a former deputy secretary of Australia’s Department of Trade.